CGAP, the World Bank’s microfinance arm, turns 15 this year, having been formed ten years prior to Muhammad Yunus winning the Nobel Peace Prize. In commemoration, Alexis LaTortue, the CEO of CGAP, wrote a summary of the state of the industry and the key transformations that have occurred over the last decade and a half. There is a lot of to unpack for a 500-word article, but I want address one point in particular that I found interesting:
More institutions are sustainable. Very few institutions were at the beginning, and there was even disagreement about whether they could be or should be. Yet, today, once you take away clients served by state banks, about three-quarters of total clients are served by sustainable institutions. In a few markets, we are even approaching saturation or real competition.
When I think about this statement, it leads to ask more questions about the implications of market saturation and sustainability for the microfinance community – the providers, the clients, the funders, everyone. I had always assumed that saturated markets already existed, but the fact that, by CGAP’s own estimate, there are only 100-150 million microfinance clients globally and a potential market of billions. It makes sense that, while some countries have relatively mature microfinance markets – Bolivia, Kenya, Bangladesh – most are far from being saturated in the way that, say, Boston is saturated with pizza shops. But in the same way that Boston has damn good pizza, when microfinance markets mature and become saturated with sustainable institutions, they begin to offer damn good financial services to the poor.
Sustainability is the goal that every microfinance institution works (or should be working) towards. It means that the organization can fully finance its operations from its revenues – interest payments and any other means of income – and doesn’t need to rely on donations or grants. But saturation is the goal of market, the kairotic moment at which point the invisible hand begins to manipulate the conditions in favour of the poor. All of the issues that are probably being discussed right now at the Microfinance USA conference in San Francisco are resolved by saturation of the microfinance market. Let’s look at them one at a time.
The most heated debate right now revolves around the inordinately high interest rates charged by Te Creemos and Compartamos in Mexico and LAPO in Nigeria. Te Creemos charges as high as 126% on its loan, well above the industry average of 35-40%. As I’ve discussed in this journal before, people find themselves firmly in one camp or another – except for your humble correspondent, who feels we can all work out a solution. Muhammad Yunus has called for the standardization of interest rates by a single governing body, the micro-credit regulatory authority (MRA). I am against this idea for a lot of reasons, not least of which are the regional differences in the costs of doing microfinance. But market saturation should create a solution to this problem. In a paper from 2006 titled “Competition and Microcredit Interest Rates,” the author discusses this principle:
It is widely assumed that competition leads to lower prices because, in a market sector in which private firms make excess profits, new firms will enter and will seek to gain customers by offering lower prices than are offered by other firms in the market. Even if no new firms enter a market, the threat of entry should galvanize incumbent firms to offer competitive prices. Lowering prices, in turn, will reduce the excess profits of firms to a level where there is no further incentive to enter the market. Ongoing improvements in firm efficiency may nonetheless enable incumbent firms to compete against each other by further lowering prices over time.
The reason that Compartamos and Te Creemos have such high interest rates is that they are the only game in town. The costs of servicing loans in Mexico maybe be higher than in other parts of the world, but not high enough to justify the interest rates they are charging. So for competing MFIs to enter Compartamos’ market, they need to either reach out to people who are not currently microfinance clients or the customers of Compartamos. To take market share from Compartamos, they need to offer a better product. Usually this means a lower interest rate, more favourable and flexible loans terms, better customer service, and more non-financial service offerings. In other words, it needs to be competitive. In response, Compartamos will be required to lower its interest rates and improve its products to compete, beginning a feedback loop that will drive the market toward some sort of equilibrium that is beneficial to the clients and the MFIs.
This is how a perfect free market works. No market is perfect, as the last three years have proven. For one thing, even in markets where Compartamos is the only MFI only a fraction of the potential clients are being served. That is, the market isn’t truly saturated. MFIs could collude to keep interest rates artificially high, or establish reciprocity agreements where they agree not to enter one another’s turf, much like the cable companies do in the United States. But the fact is that competition and market saturation will drive down interest rates. If interest rates are capped, we will be doing a disservice to the industry. Compartamos and MFIs like it are growing rapidly and reaching more clients than other institutions because they have so much capital to put toward expansion. Their success will attract new MFIs to the market. Last year, Compartamos’ stock price rallied 170% while the rest of the economy was collapsing. While funding was once a major limitation on growth, now, according to Bloomberg, Compartamos now lofty goals of expansion and operational growing pains:
Borrowers will be able to set up savings accounts with Compartamos this year, and the bank expects to expand deposits to non-loan customers, Alvarez Toca said in the April 14 interview. The company also is seeking to acquire a micro- finance bank abroad, he said.
“We’re actively looking at possibilities to acquire some institution that allows us to expand rapidly to another country and take our strategy to another country,” Alvarez Toca said.
Compartamos has 1.5 million loan customers out of an estimated 3 million people with micro loans, he said. The bank estimates there are about 9 million more potential micro-finance customers in Mexico. The biggest limit to Compartamos’s potential growth is its ability to find, hire and train employees, Lajous said.
In other words, Compartamos is a great success. The ensuing competition for clients will ensure two things. First, interest rates will fall and services will improve as MFIs push for clients. Second, more clients will be served as more MFIs enter the game. When we artificially cap those interest rates, the market will become less attractive and MFIs will have less capital for growth, leaving more poor people without access to reasonable financial services.
The reason that people are pushing for interest rate caps is to combat mission drift. Microfinance as an industry was developed to bring financial services to the poor, not to exploit them for profits. But that is what is happening in some situations. I understand this argument and agree that the social mission should be paramount in microfinance. Where I differ is in the assumption that these market forces are detrimental to the social mission. Market saturation and sustainability – the two things we have almost achieved in some places, according to CGAP – are the best things for the social mission of microfinance. Competition leads to greater client outreach, better products, and lower interest rates. I have always felt that the participants in the interest rate debate are arguing about the drapes while the house is burning down.
The disadvantage of saturation and competition is overindebtedness. When people have greater access to credit, they tend to overextend themselves and live outside their means. Much like the people of United States in the age of cheap credit, microfinance clients can take multiple loans from different institutions, borrowing from one to pay the other until the burden becomes too great. That exact situation is already occurring in parts of India, where a micro-credit bubble has left some people poorer than ever before. This is the downside of market saturation. No market is perfect, but one with companies competing for clients is invariably better than the alternative.
None of this is new. Back in 2006, CGAP released a paper trying to answer the question of why some markets had relatively flat interest rates despite increasing levels of competition. Certain conditions need to be in place for competition to have this positive effect – specifically, several large, profitable institutions with the financial wherewithal to withstand the interest rate declines that accompany competition. But in Bolivia, Uganda, and other countries, competition has led to interest rate declines without intervention from an international regulatory body. And this, in my opinion, is the best way to serve the social mission of microfinance.